Why do we want stable prices?
the value of money
the role of prices
economic stability
the value of money 
Ensuring that prices are fairly stable amounts to trying to
maintain the value of money, ie ensuring that what £1
buys today will be roughly the same as what it will buy tomorrow
or next month. If people expect the value of their money to
fall, this undermines the role of money as a measuring rod for
the value of goods and services in the economy. It no longer
acts as a standard and stable measure of value, because its
own value is falling and uncertain.
At worst, when confidence in a currency deteriorates completely,
money can stop being used as a means of exchange. When prices
were rising rapidly in Germany in the 1920s, people had so little
confidence in their currency that they demanded to be paid several
times a day, so they could quickly spend their wages before
they fell in value.
In the UK in the 1970s, the annual rate of inflation was more
than 20% for a time - what £1 would buy was reduced by
over a fifth in one year. In response, people sought wage increases
to compensate them for this decline in the value of money. This
placed further upward pressure on prices - creating what is
known as a wage-price spiral.
the role of prices
Uncertainty about the value of money - the future prices of
goods and services - can be damaging to the proper functioning
of the economy. Prices are at the core of a market-based economic
system. They help to determine what goods and services are demanded
and what is supplied. When prices across the economy are fairly
stable, specific changes in the prices of individual goods and
services allow firms and individuals to make decisions about
how much to consume, how much to produce and invest, and how
much to save or borrow. These price changes are reasonably clear
to see; they are not obscured by a general rise in prices.
But when the prices of most goods and services are rising,
it is more difficult to know which items are rising in price
relative to others. For example, if the demand for organic vegetables
is high and prices are rising, this should be a signal to other
companies to increase supply to this market. But if prices in
general are rising, it might not be clear whether the higher
price is part of this general increase or specific to an individual
product.
economic stability
When inflation is high, it also tends to be more variable and
uncertain. Many of the costs of inflation are associated with
its uncertainty.
price stability is important because high and volatile inflation
creates economic instability
Savers and lenders might want some insurance against the uncertainty
of the future value of their money, ie a higher rate of interest
for lending their money. This will mean higher borrowing costs
for individuals and firms. And uncertainty about prices and
the value of money might discourage firms from making long-term
investments.
One of the main consequences of high inflation has been greater
instability in economic conditions as a whole - periods when
demand and output have been growing strongly but then fallen
sharply. These episodes are commonly referred to as boom and
bust cycles.
In the past, when demand rose much faster than output and inflation
increased, sharp increases in interest rates were necessary
to bring demand back into line. This often resulted in large
falls in output - ie a recession - as the imbalance in the economy
was abruptly corrected. One of the costs of unsustainably high
output growth - an economic boom - and the resultant upward
pressure on costs and prices, has been large falls in output
and employment. These falls were probably greater than would
have been the case had demand and output grown in a steadier
and more balanced way.
The most recent such episode in the UK was during the late
1980s and early 1990s. Inflation rose to over 10% as demand
increased strongly. Interest rates were increased to as high
as 15%. With consumers and companies burdened by high levels
of debt, higher interest rates led to a large contraction in
demand and resulted in falling output and employment in the
early 1990s. The boom was followed by the bust. These episodes
inevitably affect individuals' and firms' behaviour. Firms find
it more difficult to plan ahead when there is uncertainty about
demand, prices and interest rates.
Alongside the relatively low inflation of recent years, output
has grown continuously. Up to the first quarter of 2006, it
had grown for the longest continuous period since the mid
1950's, when current statistical records were started. Low
inflation does not mean the end of the business cycle - there
will always be economic upturns and downturns - but the magnitude
of these swings in the future will hopefully be less than
in the past.
Monetary policy is aimed at achieving price stability. But
the goal of price stability is not an end in itself. Stable
prices are a necessary condition for the economy to grow in
a stable and sustainable way, and for the effective functioning
of prices and money in the economy.
©2000-2009 Bank of England.
